Due Diligence

By Dave Lishego

If you’re raising money from investors, at some point you’re going to have to go through due diligence. I like to think of due diligence in two phases from an investor’s perspective:

1) Validating the opportunity. Do I believe the story? Is the company bringing a unique solution that addresses a significant market need? Can this team build a big company that’s going to make me a good return on my investment?

2) Covering my ass. Is there something lurking underneath the surface could blow up this company and come back to bite me in a couple of years? Any red flags/warning signs that should scare me off right now?

This post focuses on #2. Every investor has his/her own preferred sequence of events, but generally after issuing a term sheet he/she will ask for a list of documents. Something like this or this.

If you clicked on those links, you might need this:

No, they’re not joking. Yes, someone is actually going to read through all of those documents. The process can be overwhelming and frustrating, but being prepared and understanding the investor’s rationale can help alleviate a lot of the frustration and streamline the process.

Let’s walk through some of the main categories in a due diligence request to understand what your investor is really asking.

Corporate Matters

o Has the company actually formed a legal entity?

o Does it have adequate corporate governance and controls?

o Does a Board of Directors vote on major decisions? Are they well documented?

o Who are the shareholders of this company and how are the shares allocated?

o Do founders and key employees have enough equity to motivate them through the years of hard work ahead?

o Have all securities (shares, convertible notes, debt, stock options, etc.) been legally issued and documented?

Tax/Financial/Insurance Matters

o Has the company actually paid its taxes or am I going to be surprised by an IRS audit and a giant tax bill a year from now?

o Does the company have adequate insurance coverage or are we all screwed if there’s a fire, flood, lawsuit, etc.?

o Do the company’s financial statements accurately reporting past performance?

o Any debt on the balance sheet that’s going to be senior to my investment?

Government Regulations/Filings

o Does the company have a history of issues with OSHA, EPA, EEO, etc. that are going to be problematic?

Intellectual property

o Does the company actually have protectable IP?

o If there are patents, do they cover IP that is critical to the company’s core business? Patents aren’t particularly useful if there’s an easy workaround for a competitor or they’re not relevant to the core business.

o Does the company really own its IP?

o Could an employee leave and own rights to the IP?

o Does the former employer of a key employee own the IP since it was developed on their dime?

Litigation and other legal matters

o Is anyone suing the company for any reason and am I going to get dragged into an expensive legal battle?

Contract matters

o Does anyone have a lien on the company’s assets that’s going to leave me hung out to dry if things don’t go well?

o Is the company obligated to pay anyone royalties? Other financial obligations?

o Are customer and supplier contracts real?

o Are they fair and not exposing the company to major risks?

Founder and Employee Matters

o Are the founders trustworthy? Are they going to take off with my money?

o Do any of the founders have major personal debts they’ll be tempted to pay with my money?

o Are all of the employees legally employed?

o Do they have the right to work in the U.S.?

o Are they being compensated fairly?

o Are there employment agreements, non-compete agreements, etc. in place?

I could go on and on, but I don’t want to put anyone to sleep. This is meant to be illustrative rather than exhaustive. The big question: How do you make this process less painful?

· Get organized.
Get your documents organized early in the process of engaging investors. Don’t wait until you receive your investor’s due diligence checklist to scramble to pull things together.

· Get good legal representation and a good accountant.
Find firms who have significant experience working with startups. It’s good keep your burn rate low, but legal and accounting are not the places to skimp. A good lawyer will help you avoid a lot of the pitfalls that can kill a deal and can help you identify and clean up past mistakes before sharing documents with your potential investor.

· Understand what they’re really asking.
Hopefully this post provides a glimpse into the types of questions your investors are trying to answer. Understanding their underlying concerns will help you prepare documents, anticipate follow-on questions, and facilitate a smooth due diligence process.

Originally posted on 3/27/15 to the Innovation Works blog